How Rising Rates Will Impact Home Affordability

In Wednesday's column, I wrote about home affordability and the prudence of buying or refinancing now for those who have an interest in and ability to do so. Today, I'm going to consider the math behind that general advice.

Regardless of how optimistic anyone is about the U.S. economy's ability to organically grow out of the sovereign debt levels that are now being accumulated, by the time the economy is on a path of secular growth, sovereign debt service as a percentage of tax receipts on the current trajectory will be perilously close to the terminal point I discussed in November, which will mandate the Federal Reserve having to attempt to partially inflate away the value of the debt.

In order to do so, the Fed will have to try to facilitate and manage a wide but steady spread between short term and long-term interest rates in the U.S. It is reasonable to assume as well that long-term rates, 10 years in duration and beyond, will have to be maintained in range of 12%-18% for a period of probably 20 years. Because mortgage rates in the U.S. are tied to the yield on the 10-year U.S. Treasury, this will also drag those rates up.

Whether that process begins this year or five years from now, it is reasonable that 10 years from now, a 30-year fixed-rate mortgage will be in the 10% range, and perhaps higher. For our purposes, I will use a 10% 30-year fixed rate as the point of comparison on home affordability now vs. 10 years from now. If all other variables remain the same, and only taking into account the impact of the cost of capital on affordability, the numbers are quite daunting.

By staying the same, I mean that I will assume home prices, real estate taxes, insurance, income tax rates and deductions, and mortgage qualification requirements all remain at current levels. That is, a house priced at $300,000 today will still be priced at $300,000 10 years from now.

The current par mortgage rate for a 30-year fixed amortizing loan is about 3.5%. The principal and interest payments on a loan of 90% of the value of the property add up to $1,209 monthly. Add in $375 for real estate taxes, $100 for hazard insurance, and $100 for mortgage insurance and the total current monthly debt service is $1,784.

The minimum income necessary to qualify for that loan is $3,964 monthly -- $47,573 annually. At a 10% rate on the mortgage, the monthly P&I service is $2,350 monthly, which is roughly twice as much as today. Adding in the other costs, the monthly payment requirement 10 years from now would be $2,925. That would require a minimum income of $78,000 annually to qualify for.

That means that in order for home affordability to remain constant a person making $47,753 annually in 2013 will have to be making $78,000 in 2023. That would require an annual gross increase in pay of 5% every year just to stay even on home affordability.

All this does, however, is provide a reference point from which to begin. The next thing to do is to begin to consider the probable outlook for each of the other variables over the next 10 years and their impact on affordability. It is probable that a home priced at $300,000 today will not be priced at $300,000 10 years from now. Assuming a rising nominal price point of 2% (which is less than inflation), and that same house will cost $366,000. Taxes and insurance will also be higher, mortgage interest deductibility may be lessened and mortgage qualifications will most probably be more stringent.

The bottom line is that in 10 years, a nominal income of 3x current income will be necessary to qualify to buy a home. That also means that home affordability in the U.S. will be dramatically reduced by then and probably remain that way for a generation.